Schrödinger's Market

In his famous 1935 debate with Albert Einstein, Austrian physicist Erwin Schrödinger, in an effort to demonstrate the paradox of quantum mechanics, described a thought experiment that involved a cat in a box. The box contained a poison that kills the cat when the vial is broken. In quantum theory, matter can be both a wave and a particle. Similarly in Schrödinger's narrative, the cat is both alive and dead Only upon opening the box to observe the cat can we know with certainty which is true.

Similarly, there is a raging debate about the state of the financial markets. Has inflation peaked or is it about to run up again? Is the economy in a recession or is it a soft landing? Are company earnings resilient or are cost increases going to eat them alive? And most germane to this blog - has the market bottomed?

The answers are seemingly in a box that we are just about to open.

A stark divide in opinion has developed recently over the direction of markets. I'm decidedly in the bear camp. It seems obvious to me that the market is ahead of itself. As my rally call of last month was based on a "bad news is good news". I'm now getting nervous that the "good news" recently is a bad thing. Financial conditions have perversely eased just as the Fed continues to tighten. Friday's U.S. employment report and the 'less bad than feared' earnings reports from the 2nd quarter have given the shorts enough reason to cover. But a resumption of the bull market will take much more than that. A possible 2023 Fed easing cycle seems like a pipe dream to me given the history of inflation expectations.

The inverted yield curve alone argues for caution. Gasoline prices have come down recently, dragging long bond yields with them. I believe this is nothing more than typical seasonality at work. Soon the refinery turnarounds will have been completed and heating oil production will commence, boosting the call on crude. Energy prices are set to soar back to the nosebleed levels, despite recent questionable signs of demand destruction. Russia can still cut supplies of both crude and natgas on a dime, starving Europe in retaliation to sanctions. China's demand for crude should rebound soon as it relaxes its failed Covid shutdown policy due to the growing economic rot in real estate and weaker than expected growth. SPR dispersions end in October just as the winter heating season begins. The rig count in the U.S. has started to fall already. OPEC's paltry 100,000 bbl/d hike last week was an economic bonesaw from Mohammed bin Salman to Sleepy Joe. It proves he's a MAGA adherent - 'Make America Grovel Again'.

The current weakness in real GDP - we already have a 2-quarter negative print - is a more technical reflection of the recent inflation surge than a sign of a deep slowdown. Consumer spending, strong employment, and wage costs that are approaching 10% also negate the near-term recession argument. What this looks like so far is a growth slowdown. In opposition to what we once called a 'jobless recovery', we are seeing a 'jobfull recession'. But the lagged effects on employment of Fed tightening are still ahead of us. Monetary policy operates with long lead times. It's too soon to tell if we have 'tamed' inflation.

With expectations that inflation peaking, and the markets having ripped on all the soft landing talk, the bearish camp now has its work cut out for them. The upcoming Fed communication on policy at Jackson Hole will be critical. If oil prices continue to rebound and consumers spend into the strongest back-to-school in three years, markets will give up any hope of the Fed pivot. If Mr. Powell holds true to form and drives rates up based on hot inflation and consumer data, the markets should soon test the lows of June. Remember, he's still fixated on the hood ornament as he drives. It's down the road that I worry about.

The re-establishment of a positively sloped yield curve, however it is achieved, is not priced into the market. If the 10 yr bond yields 3.50% or higher next year because of inflation, I don't see any way the S&P500 will be higher in six months as valuations will be hurt. If the 2 yr bond yields less than 2.5% due to a recession, I don't see the S&P 500 higher in the next six months, as earnings will be hurt.

With apologies to my feline-loving fans, I think the cat is dead.

Risk Model: 4/5 - Risk On

Sentiment and volatility often go together. Both have signaled a risk-on stance, with the 'peak inflation' narrative and ample unrisked cash combining to force-feed the risk markets. Quiet summer markets with low liquidity can often turn nasty in the September return to work. Importantly, if the economy is truly 'landing' wouldn't we be seeing Dr. Copper forecasting just such a recovery? A feeble bounce in Copper based on a pull-back in the U.S. dollar hardly counts. This still looks like a bear market rally to me.

Small Caps have out-performed their larger brethren reflecting the resilience of the U.S. economy and undemanding relative valuation. Despite that, they seem a bit overbought in the short term and we have yet to see positive economic revisions that will be required to generate positive absolute returns for these companies. I've taken a trade on my $IWM position already. I'm long oil now. Long volatility and gold is usually a good hedge into September as well.